Today's Economist

Cutting the Corporate Tax Would Make Other Problems Grow

The current debate over corporate inversions, in which American companies like Burger King consider renouncing their citizenship for tax-reduction purposes, is only the latest reminder that the United States corporate tax code has deep problems.

The basic idea behind abolition is that the current corporate tax code is fraught with wasteful loopholes — each of which has politically power defenders — that both lose revenue and distort business decisions. The abolitionists ask: Why not give up on the fiction that we can adequately and efficiently tax companies and instead tax their shareholders at higher income-tax rates?

But as imperfect as the corporate tax may be, the end of it would create all kinds of problems and disadvantages. Here is a breakdown of those drawbacks:

The corporate tax is an important balancing mechanism in an era of great inequality. According to the Congressional Budget Office, about 80 percent of corporate income is held by households in the top fifth of the income scale, and about 50 percent is held by the top 1 percent. Unless we could replace it with higher taxes on those same households — a daunting proposition, as I’ll show in a moment — scrapping or even just lowering the corporate tax rate would increase after-tax income inequality.

When corporate profits as a share of national income are the highest on record, with data going back to the late 1920s, it suggests that the current corporate tax system, with all its shortcomings, is hardly killing the competitiveness of American companies.

Another reason abolishment is a bad idea: If you think we’ve got tax avoidance problems now — and if you don’t, you’re not paying attention — we’d have a much bigger problem with a zero tax rate on incorporated businesses. Most of us don’t manage our taxes. We just pay them. But as your tax bill goes up, you will aggressively look for ways to shelter your income. (More precisely, you hire people to do that for you.)

For example, in order to avoid the higher rate on personal income, fund managers tap the “carried interest” loophole so their earnings are taxed at the lower capital gains rate. To see some really deep tax avoidance, you’ve got to travel abroad to tax havens like the Cayman Islands, where American deposits in their banks amount to about 550 percent of the country’s G.D.P.

Here’s another element to understand why abolishing the corporate rate would go badly: In order to avoid corporate taxes, more than a third of business income is now “passed through” to the owners to be taxed at the individual level. That’s up from 13 percent a few decades ago, and it’s one reason corporate taxes as a share of G.D.P. and a share of federal revenue have fallen from about 4 percent and 20 percent in the 1960s to less than 2 percent and 10 percent today.

Those who would get rid of the corporate tax basically argue that the smart move is to go with this flow: As long as so many more businesses are setting themselves up to avoid the corporate tax, don’t fight ′em, join ′em.

The problem is that to do so risks turning the corporate structure itself into a big tax shelter: If income generated and retained by incorporated businesses should become tax-free, then guess what type of income everybody will suddenly start making? Taxes delayed are taxes saved, and with no corporate tax, anyone who could do so would structure their earnings and investments to be “corporate earnings,” untaxed until they’re distributed.

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To see the relative efficiency of the current arrangement, think about alternative ways of designing a system to tax undistributed corporate profits. What if I held shares for a day? A week? Suppose dividends were paid out that week? It would be very hard for the I.R.S. to keep track of this, which some of the corporate tax abolitionists acknowledge.

You could tax the accrued earnings on corporate stock held over the course of a year, but taxing shareholders on unrealized gains represents a huge change in tax policy that would be aggressively resisted by patient holders of equity. They’d view this trade-off — a tax on unrealized capital gains in exchange for ending the corporate tax — as an awfully big stick for a pretty scrawny carrot.

Advocates of ending the corporate tax tend to underestimate the difficulty of replacing the $275 billion in revenue it raised last year. The Upshot’s Josh Barro, who has written thoughtfully about abolishing the tax, admits that one widely cited plan “would collect only about half as much revenue as would be lost by abolishing the corporate income tax.”

Filling the revenue hole could be solved partly by raising taxes on the wealthy, as he notes, but suppose it’s not? Who then will bear the burden of making up the lost revenue?

The abolitionists argue that since we already tax lots of business income that’s passed through to the individual’s tax bill, there’s no reason we can’t do more of that. The problem is, we do an even worse job taxing non-incorporated business income than corporate income.

One study found that the tax gap — the share of taxes owed but not collected — was 17 percent for corporations and 43 percent for business income reported by individuals. That research is over a decade old, but more recent tax gap research found that business income taxed at the individual level was the single largest source of the gap, and that sole proprietors report less than half of their income to the I.R.S.

Rather than create a new shelter in a world where tax avoidance is already an increasing problem, it would be better to mend the current code. Here too, however, those on my side of the argument are guilty of the same hand-waving as the corporate-tax abolitionists. “Broaden the base” — i.e., close loopholes — and lower the corporate rate sounds a lot easier than it is. My loophole is your treasured “job creation program.”

But there is no tax reform wherein everyone ends up better off. The rules that guide us therefore must be efficiency — closing business tax loopholes that are widely agreed to be wasteful, like carried interest and inversions — and protecting the revenue base. Creating a new way to shelter business profits violates both of those simple ideals, which is probably why every other advanced economy has a corporate tax.

Believe me, as someone who’s been debating this issue for decades, I recognize how tempting it is to just chuck the whole corporate code. But to do so now would only further encourage tax avoidance and erode an already diminished tax base.

Jared Bernstein is a senior fellow at the Center on Budget and Policy Priorities in Washington and a former chief economist to Vice President Joseph R. Biden Jr. Follow him on Twitter at @econjared.